Pretty much on a daily basis, I see people posting in various trading groups, on Twitter, etc. with screenshots of “trade calls” using price based indicators – especially ones like VWAP, POC, various EMAs, etc. – and constant questions about what the best one to use is, which MA on what timeframe, etc. Unfortunately these people are clearly not understanding (or are unaware of) a very simple, basic fact about these averages of price. They are an average of price!
In computer programming (and other disciplines too, to be fair), there is a concept known as “Garbage In, Garbage Out.” What this means is that if you have a theory, formula, equation, etc. and you put a nonsensical number, idea, concept, etc. into it (or you simply don’t understand what you are actually putting into it), then you are sure to get a nonsensical result. Garbage went in, garbage comes out. And this is exactly what happens to people trying to trade using any averages of anything to tell them what to do and when, or where price is going to go. Think price reverts to the mean? Allow me to illustrate how terribly, dangerously wrong that idea is.
Let’s not even start with any prices of anything. Let’s just talk simple concepts. Say we have two numbers, 1 and 99. If you were to compute the average of these, you would and them together (equaling 100) and divide by the number of “items”, in this case that’s 2, and end up with 50 – exactly in the middle. That’s what an average is, add up the total of whatever, and divide by the number of whatevers.
Now let’s look at a moving average. This one changes over time. But how does that work exactly? Well let’s say we start with a range of 2 numbers. Say it’s between 1 and 9. So the average, would be 5 (10 divided by 2). So we have a “Simple MA” of 5. Now say the range expands. It’s now between 1 and 15, so the new average, is 8 (16 / 2). And so it continues, as long as the range of numbers change, the average will change, and you can plot those values easily on a chart/graph, draw a line connecting them, and presto – you have a moving average!
So here’s were the theory of “reversion” comes in. The idea is that price will always eventually return to its “mean”, or simple average. So by this way of thinking, if we imagine that our range is a range of prices, and price is at 100 while the average is at 50, price will have to revert to 50. It’s math, and math doesn’t lie!
But what this fails to take into account, is that the average is a result of price, and price is moving! The average never dictates what price will do, it’s exactly the other way around. Price dictates the average by moving. So while yes, in time the price and the average of price are going to move towards one another, what is actually happening is that both of them are moving, and they will always be trying to converge on one another, because the average is always “chasing” the price.
Now in financial markets, price tends to oscillate around the average… above it, below it, above, below, etc. And this is what creates the illusion that price reverts to the average. But it’s just that – illusion. The dangerous part is that price absolutely does move back to cross the average (depending on which average, but that’s another rant!), but when it does the average is no longer where it was. Unfortunately people can make money from time to time on this assumption, which then leads to “resulting” and believing that “it works” and there’s an edge to it. But they literally don’t understand what makes an average, in the first place.
It doesn’t matter what kind of average we’re talking about. VWAP, POC, SMA, EMA, Wilder’s, they are all still outputs of price, and price by itself in any given instant, is arbitrary. “Arbitrary in, arbitrary out,” one might say. It’s also always late, since an average results from price and can only happen after price has done something. Now add to all of this, that the trader is looking at an average on a specific timeframe they have arbitrarily chosen, and you truly have “arbitrary garbage in, arbitrary garbage out.”
But if it’s such garbage, why do so many people swear by it? After all, millions of people can’t all be wrong, can they? Remind me again, what is the percentage of traders who are unprofitable? 🤔
Millions of people absolutely can be, and are, wrong all the time. In fact the markets require them to be, in order to function. After all, their money has to go somewhere. Wouldn’t you rather it be into your account? Learn to use better cues than averages (such as volume at price), and you’ve got a shot.
Until next time, good trading!
Jonathan van Clute
Community Manager, Trading Research Group